Why do some models behave badly?

In his latest book Models.Behaving.Badly: Why Confusing Illusion With Reality Can Lead to Disaster, on Wall Street and in Life, the physicist-turned-economist Emanuel Derman looks at how a superficial resemblance between the equations of physics and those of economics has led to confusion in the financial industry.

Yesterday, Derman was at the Institute of Physics in London to speak about the differences and similarities between models, theories and intuition. You can watch a video of his presentation above.

The take-home message of the talk is that financial models are never theories, rather they are metaphors. As such, financial modellers must explain the shortcomings of their models to the rest of the world.

To encourage openess and honesty from the modelling community, Derman and the mathematican and modeller Paul Wilmott published the Financial Modelers’ Manifesto in 2009. The 1300-word document ends with “The Modelers’ Hippocratic Oath”. My favourite line in the oath is the first, which reads “I will remember that I didn’t make the world, and it doesn’t satisfy my equations.”